Flexit

Mark Carney, Governor of the Bank of England (BoE), has been a controversial figure at times, especially when commenting on Brexit. His previous remarks have pleased some but angered others, which just goes to show you cannot please everyone all the time.

This week his comments were reassuring. He indicated ways the BoE can operate policy flexibly around Brexit.

Before we look at the details it is worth reminding ourselves of the Bank’s core objectives; financial and monetary stability. The Bank of England, nicknamed the Old Lady of Threadneedle Street, is the lender of last resort for UK banks making the institution a key part of the economic fabric of our country. She may be old, but actions announced by Carney show she can be nimble.

In relation to maintaining financial stability​, liquidity and maintaining capital adequacy are essential, therefore the changes below are very welcome.

1. access to liquidity (finance) will be increased in the weeks surrounding Brexit, 12th March – 30th April 2019, and

2. the frequency with which repurchase agreements (repos) will be offered is to increase from monthly to weekly.

The role played by repos and even the terminology around it sound complex. However, in simple terms repos allow banks to offer illiquid assets on their balance sheet, such as mortgages and loans, as collateral in return for cash loans. Therefore, if banks come under any stress they immediately have access to short-term funding. i.e. ensuring they remain able to function normally during periods of turbulence.

Lessons have been learned from the 2008 financial crisis and the BoE approach to possible disturbances is now normal, prudent, contingency planning. This ensures the financial system is insulated from shocks and when ‘events’ occur they are not exaggerated. In fact, the facilities put in place for the UK exiting the EU were successfully used around the time of the Brexit vote in 2016 and were planned to be put in place around the 2014 Scottish Referendum.

In terms of the second objective, monetary stability, the BoE seek to manage inflation, which if left to its own devices can be extremely destabilising. For example, disruption to supply chains could lead to an increase in inflation. Equally, upward pressure on prices from demand shock could occur. Therefore, the BoE conduct monetary policy appropriate to the circumstances unfolding at the time and have said raising interest rates isn’t out of the question.

Gauging the inflation outlook is tricky. Stories of households stockpiling leading to an inflation spike have been mentioned in the press, but this doesn’t really show up in the data. Inflation SWAP rates, on a 5-year forward looking basis, since September 2016, are shown stuck in a narrow channel; ranging between 3.25% and 3.75%. Today’s inflation SWAP rate is at the upper end of its recent range, at 3.55%, but above the BoE’s 2% inflation target. Inflation SWAPS indicate a breakeven rate between those investors expecting inflation to increase and those on the other side expecting inflation to fall and we can see that it has recently started to drift down again.

5 Year UK Inflation SWAPS – An Inflation Gauge

Source: Bloomberg, February 2019

We also saw inflation expectations rising in the aftermath of the Brexit vote to leave the EU back in June 2016, but the global economy subsequently grew above trend. The growth backdrop globally is highly influential and it impacts investor expectations of future prices. With global growth easing we can see why it has dipped.

It is business as usual for the BoE and the actions taken show they are not being complacent. Carney is demonstrating, to speculators and the wider investment community, that the Bank will be flexible and not afraid to take all necessary action to ensure financial and monetary stability.

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